When it comes to mutual fund costs, expense ratios take the spotlight–with good reason. Expense ratio data is readily available and its effect on performance is well-documented: Less expensive funds tend to outperform. Tax costs are significant and considered, too, but most funds and investors are sitting on a decade of flat returns and embedded losses, muting the attention paid to taxes.
Trading activity represents a big hurdle to any investment strategy but receives little discussion because the full costs aren’t reported and are difficult to estimate. You’d need data on every single trade to capture the true picture, but funds are only required to disclose holdings quarterly, rendering it impossible to know exactly what a manager traded, under what conditions, and when.
Of the main components to trading costs, only one is measured and disclosed by the fund companies–brokerage commissions paid to those executing the trade. Brandywine and Hussman funds post brokerage commissions as a percentage of net assets prominently in shareholder letters. The vast majority of funds bury the absolute dollar figures deep in the Statement of Additional Information, making it difficult for investors to find and interpret. Morningstar recently started collecting brokerage-commission data from fund filings. (We’re not yet posting this data on the fund data pages but have plans to do so later this year.)
The Hard (and Soft) Facts of Brokerage Payments
The brokerage commission figures we gathered were eye-opening. As displayed in the table below, the average equity fund pays approximately 0.30% of assets a year. That’s roughly 30% of the average no-load large-cap fund’s expense ratio. Thus, brokerage commissions can take what looks to be 0.90% paid in expenses each year up to 1.20%.
Average Brokerage Commissions as a per cent of Net Assets
2009 2008 2007 Domestic-Equity Funds 0.29 0.22 0.36 International-Equity Funds 0.30 0.31 0.22 Where do these costs come from? When we discuss trading with fund managers and traders, they tell us that commissions can run from fractions of a penny up to five pennies for every share of stock they buy or sell, depending on the trade and whether research services are bundled in. Electronic trading networks are on the cheap end and full-service brokers offering research are on the high end of that range.
Many funds conduct more expensive trades with selected brokers in exchange for research services paid for with “soft dollars.” The cost is “soft” because the fund is paying an inflated cost to trade and is receiving a different service in return. Arguably, the brokers providing research for soft dollars have an underlying incentive to invite more trades–and thus more commissions–but not necessarily to provide the best research. The soft dollar system makes it hard to know how your dollars are being spent. If the outside research is needed and good, then the fund should buy it, but it’d be cleaner to pay for it with hard dollars. Research costs should be part of the management fee, and only the cost to execute the trade should be labelled a brokerage commission.
Shelling Out the Big Bucks
While the average brokerage cost is significant, much more startling are the huge fees paid by some individual funds that in some cases approach or exceed the entire expense ratios of many core funds. We’ve reviewed the data from the past several years, run the calculation, and highlighted 10 prominent funds that paid a lot in brokerage commissions in 2008 and 2009.
Tip of the Iceberg
The trading-cost picture is far from complete, and we’ve only considered one piece of it here. Market impact and opportunity costs are the tougher and more important pieces to measure because they can easily dwarf brokerage commissions. Putting together a true picture of the trading costs is an important part of the overall investment picture and well worth further study, something Morningstar hopes to keep pushing forward.
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